Background: I’m exploring an idea called Evergrow, and wrote up a list of 30 questions relating to the idea. I’m now going through and answering each of these questions. Answers to questions 1-3 are here. Answers to questions 4-8 are below.
Q4: How does the California cap-and-trade program work? Any notable features? How does it compare to other major cap-and-trade programs, e.g. the EU ETS?
In 2006, the California legislature passed Assembly Bill 32, the Global Warming Solutions Act. AB32 enacted a broad suite of climate change and greenhouse gas mitigation programs, with a goal of reducing California’s GHG emissions to 1990 levels by 2020, and an 80% reduction from 1990 levels by 2050. One major piece of AB32 is a cap-and-trade program, which came into force on January 1, 2012.
As the world’s 5th largest economy, California has enormous influence over global GHG emissions. The California cap-and-trade program is one of the largest emissions trading schemes in the world. It is also the only state-wide cap-and-trade program in the United States. Roughly 400-500 businesses and entities in California are covered under its cap-and-trade program, primarily in energy and heavy industry. Together, these businesses represent over 80% of all emissions in California. The program has achieved 100 compliance in each compliance period to date, enabling California to hit its 2020 GHG emissions reduction goal in 2016, 4 years ahead of schedule. The program was recently extended (with some modifications) through 2030 by the California legislature.
Under cap-and-trade, if a business in California emits a certain level of GHG emissions, it must have a permit for each metric ton of GHGs that it emits. Emissions are capped in the aggregate on a statewide level, and this cap decreases every year, forcing an overall reduction in emissions. Businesses may trade permits amongst each other, creating a market for the reduction of emissions, and giving businesses flexibility in finding the lowest cost options to reduce their overall emissions. Hence the term “cap-and-trade”. The program is administered by the California Air Resources Board (“ARB”).
There are two types of permits (called “compliance instruments”) that businesses can get to cover their GHG emissions: allowances and offsets. Allowances are the primary compliance instrument. Each year, the ARB allocates allowances to businesses via a free allocation and auction. Businesses can buy and sell allocations with each other. In addition, businesses may use offsets to cover up to 8% of their emissions. This 8% number will decrease to 4% from 2021-2025, increasing to 6% from 2025-2030.
At the start of each calendar year, businesses must surrender compliance instruments for 30% of their previous year’s emissions. Then, within 10 months of the end of a “compliance period” (typically a 2-year calendar period), businesses must turn in compliance instruments that cover their remaining emissions in that compliance period. The penalties for non-compliance are severe. If a business is late or has a shortfall, they must later turn in four compliance instruments for every ton of emissions not covered in time. Once a business submits compliance instruments to the ARB, the instruments are retired.
One unique feature of California’s cap-and-trade program is the use of price controls on allowances and offsets. California sets a price floor and ceiling on the price of both allowances and offsets in its market. The purpose of these controls is to (a) avoid the high price volatility of carbon instruments seen in predecessor programs, such as the EU ETS, and (b) provide a degree of price certainty to both businesses and carbon offset developers. Another unique feature of California’s program is the strict regulation and monitoring of offset projects; it is generally much more difficult for offset projects to become certified in California than under other offset protocols.
Q5: Describe the offset market and pricing in California. Who are the buyers and sellers? What are the buyer motivations? How do they buy? Where does their budget come from? What is the total and average transaction volume? What is the duration over which carbon pricing has a price floor? What price risk over what duration are buyers and sellers exposed to? What (tail) risk is there in the form of legislative or regulatory change? What does the forecasted market demand for offsets in the future look like?
Companies subject to California’s cap-and-trade program can use offsets in lieu of allowances to satisfy their compliance obligations. This makes sense when offsets are cheaper than both (a) changing business practices to reduce emissions, and (b) purchasing allowances from other businesses subject to cap-and-trade. The demand and willingness to pay for offsets is thus a function of the prevailing or forecasted costs of emissions abatement and allowances.
Forecasting the cost of abatement, the price of carbon allowances, and market for offsets is complex. Historically, there have been periods when the California market had an oversupply of carbon allowances, primarily because ARB awards free allowances to certain businesses to lower their cost of compliance and prevent spikes in key commodities such as energy. However, AB32 has a number of mechanisms that prevent a long-term collapse of carbon pricing.
First, there is a floor on the price of carbon allowances in the California market. The ARB has a reserve price at its quarterly allowance auctions, currently at approximately $15/ton, which rises at 5% plus inflation each year. Second, whenever an auction for carbon allowances is undersubscribed (i.e., more allowances are available for sale than are purchased), those excess allowances are held in a state reserve and cannot be sold until at least two subsequent quarterly auctions clear above the ARB’s reserve price. This artificially constrains allowance supply, creating upward pressure on pricing. Third, because the overall cap on emissions continues to decrease each year, the market has a natural tendency towards equilibrium above the price floor.
For these reasons, many commentators forecast a robust market for California Carbon Offsets (CCOs) in the future. For example, Stillwater Associates estimates that in several years from 2020-2030, demand for CCOs will outstrip supply, and The American Carbon Registry forecasts that the CCO supply may be completely exhausted by the latter half of the current decade, resulting in an average price of $46.5/mtCO2e between 2021-2030. The ACR’s forecast for the impact of AB398 (the bill that extended cap-and-trade through 2030) on CCO pricing is particularly interesting, as it forecasts a large shortfall of both in-state offsets and offsets overall through 2030. According to the ACR, there is a shortfall of approximately 65 million CCOs through 2030, which at their average price of $46.54/mt/CO2e is worth just over $3BN. Here is a list of companies and their offset usage in a recent compliance period – there is the full spectrum of offset usage in this list, from companies that use 0 offsets to companies that use the entire allowable amount.
CCOs are sold in both primary and secondary markets. In primary markets, buyers purchase CCOs directly from a project developer. In secondary markets, buyers and sellers transact in non-project specific CCOs, either through brokers or through ICE, a subsidiary of the NYSE. CCOs have vintages corresponding to the year in which the offset project “commenced” according to ARB (e.g., “CCO 2019”). Companies can use offsets from past and current vintages in a given compliance period, but may not use future vintages. For example, for the 2017-2019 compliance period, a company could use CCOs with any vintage up to 2019, but not 2020 or beyond.
Not all CCOs are the same. The market has evolved to trade several types of CCOs, differentiated primarily by whether or not the buyer or seller holds or retains certain risks relating to future offset invalidation. These are discussed in Question 8 below. In addition, AB398 created two classes of CCOs: CCOs originating from projects produced “direct environmental benefits” (DEBs) to California, and those which do not. From 2021-2025, companies may use offsets in respect of 4% of their compliance obligations, but only half of this (i.e. 2%) may be from offsets that do not provide DEBs. From 2026-2030, this rises to 6% and 3%. The ARB is yet to issue precise guidance on DEBs, but many commentators think that there is likely to be significant dislocation in pricing between DEBs and non-DEBs CCOs.
Q6: How does the offset futures market in California work? Who are the market participants? Is the market speculative, or do sellers need to have assets in the pipeline in order to participate? Is there an exchange, and/or are transactions handled privately? Are there brokers or market makers?
In April 2019, Shell Energy and ClimeCo traded the first CCO futures contract on an exchange. Shell Energy was the buyer, ClimeCo the project developer, and the ICE was the exchange. In the past, buyers could work with offset project sponsors to fund project development in exchange for a share (or all) of the offsets from the project, but doing so required a project-level investment and the assumption of operational risks by the buyer. The Shell/ClimeCo transaction is the first example of an exchange-traded CCO that carries no invalidation or operational risks. The deal was for 25,000 CCOs to be delivered in December 2021, and was priced at $16.66 per offset, a roughly 13% discount to the prevailing CCA settlement price of $19.17. It’s unclear to me whether or not ICE or buyers would accept listings for CCO-futures by purely speculative sellers (e.g., a hedge fund).
Q7: How do you create an offset, procedurally, in California? Is the qualification process “as-of-right” or is the approvals process discretionary? Is there a cap on approvals or the creating of new carbon offsets?
The ARB has published 6 specs (called “protocols”) for offsets. Any project that seeks to produce offsets valid for use in California needs to conform to one of these 6 protocols. Each protocol is well-defined, and contains very specific rules around project eligibility, specifications, calculations for offsets per project, and more. The 6 protocols are:
- Ozone Depleting Substances Projects
- Mine Methane Capture Projects
- Rice Cultivation Projects
- Urban Forest Projects
- Livestock Projects
- U.S. Forest Projects
Of these, the U.S. Forest Projects protocol has produced the overwhelming majority of offsets to date (over 80%). An index of ARB offset protocols is here. In addition, ARB recently voted to endorse a new Tropical Forest Standard, which may lead to the creation of a new protocol using non-US tropical forests as a source of offsets in the future.
Procedurally, the process for creating valid offsets starts with the project developer listing their project with an approved third-party registry, such as the American Carbon Registry or Climate Action Reserve. The registry will then review the submission for completeness and list it on its website. The project developer then provides periodic reports to the registry over a 1-2 year period on the progress of the project. At the end of this period, the registry issues “registry offset credits” to the project, which are a kind of preliminary offset credits that are not valid for use as a compliance instrument in the California cap-and-trade program. However, these registry offset credits can then be converted into “ARB offset credits” by the project developer. To do so, the developer must submit additional documentation to the ARB, who as a final step certify the project’s compliance with its protocol and any other prevailing regulations. The process takes approximately 2 years in total from initial listing to final crediting.
Q8: What are the ongoing obligations for offset buyers and sellers in California? Do we assume any contractual obligation or liability through the sale of a carbon offset to a buyer? How about a buyer? Are there any ongoing requirements like reporting and recertification? Is there anything we risk defaulting on? Do the buyers assume obligations when they buy or retire offsets?
The major ongoing risk for buyers and sellers of CCOs is invalidation risk. Put simply, if in the future the carbon sequestration claims of a given project either do not materialize or are reversed, then the ARB will invalidate a corresponding amount of offsets for that project. If a buyer has used invalidated CCOs as credit toward a compliance obligation, they will need to make ARB whole on the difference, leaving them exposed to the spot price for CCAs and CCOs at the time of invalidation. Given that the ARB requires very long validation periods – up to 100 years in the case of forestry protocols – this risk for buyers is significant.
As a result, the market has evolved a number of mechanisms for structuring and allocating risk between buyers and sellers. On one extreme are so-called CCO-0s (“CCO-zeroes”), also called “golden offsets”, in which buyers bear zero risk of invalidation and sellers bear 100% of such risk. The market also trades CCO-3s and CCO-8s, in which the buyer is exposed to invalidation risk for 3 and 8 years respectively. However, given the long timelines involved, even CCO-0s require the buyer to assume a fair amount of risk in the form of counterparty risk. For example, let’s say you buy 100 CCO-0s from a forestry developer. 6 years later, some or all of the CCOs are invalidated, but the developer has since used or distributed its proceeds from the offset sale and is thinly capitalized. How good is your “zero-risk” contract now? For this reason, a number of commentators have pointed to invalidation risk as the main reason that historically, companies haven’t used as many offsets as they could have.
Sources & further reading:
- Summary of California cap-and-trade program by Stillwater Associates
- List of covered entities and market participants in California cap-and-trade program
- Analysis of Y1 of cap-and-trade by EDF
- Overview of allowance auctions
- Index of cap-and-trade programs in the world
- CA Carbon Market Outlook by NewForests
- Haas Energy Institute Supply/Demand Analysis of CA Cap-and-Trade Market through 2030
- Overview of CCO products and market
- ICE page on CCO futures
- Process for offset credit issuance
- Offset surrender history
- How do companies forecast and budget for cap-and-trade compliance expenses? How do they make decisions on build/partner/buy regarding abatement vs buying CCAs vs buying CCOs? How about the timing of retirement/predicting price in the future?
- What other markets/linking?
- How “real” do listings need tobe on ICE for CCO-zeros?
- DEBs seems like it could be an issue going forward. I wonder if the market will evolve a DEBs CCO and non-DEBs CCO; this seems likely.
- I wonder what the market prices counterparty risk in CCO-0s at. In other words, what is the spread between CCO-0s and CCAs (which truly bear zero risk), and is that “right”?
- As you approach the end of an invalidation period, do CCO-0s, 3s, and 8s appreciate in price, similar to a bond approaching maturity?
- I’ve seen one or two small companies offer invalidation insurance as a standalone product (see, e.g., here). I wonder if you could go further and hold CCOs in a pool, together with cash, and then write insurance policies backed by actual assets to companies or sellers exposed to invalidation risk. Or perhaps use that same pool to finance abatement projects with zero risk of failure to deliver the expected benefits (because in the event that happens, the pool makes up the difference with CCOs).