Falling near-term contract prices suggest severe bearishness in California cap-and-trade market

April 27, 2014 by CaliforniaCarbon.info

CaliforniaCarbon.info, April 26, 2014: Since the negative price discovery at the underwhelming February auction (when the secondary-traded current benchmark CCA instrument lost 25 cents in two trading days after the release of results), prices have recovered in two spurts: once when they partially rebounded in the same week of the fall itself (V2014 Dec 14 regained 13 cents by the close of that week), and again two weeks ago with a steady, gradual rise (with the V2014 Dec 14 touching a post-auction high of $12.01).

These gains have now all been lost. The current benchmark is now back at $11.85 on the InterContinental Exchange (ICE), exactly where it had fallen to right after the release of the February auction results. This price pattern is repeated across virtually all deliveries for 2014 and 2015 (albeit with less steep declines for the latter), even as theV2016 Dec 16 has managed to hold level and in fact post an upward trajectory during the past week rising 10 cents week-on-week to close at $12.70.

Near-term deliveries seem to have been the most affected by the bearishness in the market, with June 2014 contracts losing some 11 cents week-on-week. Both the V2013 Jun 14 (eligible for usage this November for compliance surrender) and the V2014 Jun 14 (not eligible) fell from $11.80 to $11.69, a mere $0.35 above the defined price floor of $11.34 for 2014. Furthermore, the lack of a value difference between the two vintages adds to suggestions the market does not presently foresee a near-term shortfall heading towards the first compliance surrender date.

Further out, prices fell by about 9 cents week-on-week for end-2014 deliveries including the current benchmark contract, and by about 5 cents week-on-week for 2015 deliveries. The V2014 Dec 15 returned to $12.25, the lowest since the February price discovery, as it has already done on several occasions since.

This downward price trend did not produce much activity on near-term vintage-delivery combinations either. Excepting what appears to be a single large trade of 2.5 million V2016s delivering in December 2015 (executed on Wednesday), and 495,000 other V2016 Dec 15s that were contracted, only 385,000 V2014s were contracted all week. Of these, 124,000 will deliver either this month or next.

While one compliance instrument (CCA or CCO) has to be retired for every metric ton of emissions covered under the program’s cap, demand for allowances does not at present equal the volume of firms’ covered emissions. Firstly, offsets may be used to fulfil up to eight percent of a covered entity’s obligations, and are a vital part of the cost containment plans. With the uncertainty in the lead-up to Friday’s final Board presentation of the regulatory amendments over whether the annualisation of the offset usage quota created a use-it-or-lose-it situation, it is conceivable that some firms may have looked at weighting their procurement strategy towards acquiring offsets rather than allowances with a view to this year’s surrender. Fortunately, ARB has now clarified that entities who do not exhaust their eight-percent allotment at the annual true-ups can make up the unused portion at the triennial deadline.

Secondly, a large portion of allowances in the program as things stand continue to be allocated free-of-charge to trade-exposed industries deemed to be in need of transitional assistance, so as to allow them to adjust to the imposition of compliance costs without being disadvantaged vis-à-vis their competitors operating from outside California. For 2014, 54.4 million allowances are allocated gratis to certain industrial sectors, chief among them petroleum refining (28.7 million), crude and gas extraction (10.1 million), and cement manufacturing (6.8 million). This accounts for just over a third of the 159.7 million metric tons permitted under the cap. If these instruments come to be banked (rather than resold), there is a direct reduction in demand for allowances either at auction or on the secondary market. While this ‘introductory’ assistance feature had been due to ease off beginning in CP2, the latest regulatory amendments will uphold existing assistance levels into CP3 (2018), which will impede growth in demand for allowances. There are further indications that certain sectors – notably ‘big oil’ – that will in fact ask for increases in assistance factors moving forwards, while it was also confirmed that universities and other public service facilities, including public wholesale water facilities, will receive maximum assistance under the amendments.

What further challenges a long market is the generosity of supply, whether provided by auctioned or allocated allowances. In CP1, the volume of the cap declines by only 2% from 2013 to 2014; in CP2 and CP3, the annual cap reduction increases to 3%. Given the presence of a wide palette of complementary measures designed to reduce emissions from a variety of sectors including power generation and transportation fuels, there have been arguments to suggest that these 2-3% annual reductions are not ‘additional’. In a market where supply comfortably fulfils demand, prices may be expected to move in a narrow band just off the primary market floor, and to exhibit little volatility. These are characteristics of a bearish market.

Weak demand for allowances is expected to be exacerbated by other measures which will now become part of the cap-and-trade regulations. The effect of the creation of thirteen ‘safe harbours’, or instances of behaviour that constitute permissible reallocations of resources rather than ‘resource shuffling’ (which is the act of electricity companies receiving credit based on emissions reductions that have not occurred), has been estimated by independent consultants at a potential annual reduction in demand of 15 million allowances. In an earlier analyst note which forecasts emissions from the power generation sector, CaliforniaCarbon.info put the cumulative shortage in 2020 faced by this sector within a range of 23 to 71 million tons. Changes to the resource shuffling provisions have the potential to turn this shortage into surplus.

The first auction of 2014 (in February) was an underwhelming one, with the bid ratio falling to 1.27 from the 1.85 seen last November (itself down from 2.49 in Feb 2013). Prices cleared at $11.48, a mere 14 cents off the floor, for the current auction, the slimmest margin seen since the inaugural auction in November 2012, when caution arguably produced a clearing price of $10.09. These figures would seem to substantiate arguments that (1) supply comfortably meets demand, and (2) such conditions are proving unattractive to greater speculative participation. Capital flight deprives the market of a useful means of holding allowances at lower cost, since speculators often have recourse to cheaper capital than several types of compliance entities.

With the bearishness of the 2014 market possibly being augmented by the amendments that have just been passed by the Board, it is quite unlikely that either price levels or interest in the next auction (May 16) will return to their 2013 levels.

For more information regarding this article, please write to contact@californiacarbon.info.

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